Dry Run In Markets Behind Regulator’s New Thinking, To Review Issue At Today’s Meeting
New Delhi/Mumbai: The government and financial regulators are set to ease some of the restrictions imposed on foreign portfolio investors last year, as part of efforts to bolster capital inflows that have been slowing lately, according to people familiar with the matter. Capital market regulator Sebi is likely to discuss a proposal to this effect at its board meeting on Monday.
Foreign institutional investors (FIIs), who were barred from holding more than 40% of their assets in participatory notes (PNs), could be given some flexibility on this count in the wake of the changed scene in the domestic financial markets. The 18-month deadline—ending in March 2009—to unwind certain PN positions is also likely to figure at the meeting, sources said.
In October 2007, Sebi had banned either fresh issuance or renewal of PNotes by foreign portfolio investors or their sub-accounts in cases where the underlying Indian security were derivatives. These investors were then directed to wind up their current positions over 18 months. It was also decided then to cap the percentage of PNotes, or offshore derivative instruments (ODIs), outstanding at 40% of the total assets under custody of a registered foreign portfolio investor.
One option could be to extend the March 2009 deadline for winding up of positions in cases where PNs have been issued with derivatives as the underlying. A more rigorous Know Your Client (KYC) norm may also be imposed to address concerns relating to money laundering and terrorism financing, if the proposal to ease the curbs goes through.
With the seizure of the credit markets abroad and the attendant squeeze on liquidity, capital inflows into India, be it in the form of portfolio inflows, foreign borrowings or private and venture capital, have been hit over the last few months. FIIs have so far taken out around $10 billion while foreign borrowings have totalled near $10 billion so far compared to net borrowings of $22 billion during the last fiscal. Foreign direct investment flows, though, have been robust at over $10 billion in the first quarter of this fiscal.
However, given the assessment of significantly lower inflows that are to continue in the next couple of quarters, the government, securities market watchdog Sebi as well as the Reserve Bank of India (RBI) are all considering whether to ease the October 2007 restrictions imposed on FIIs in the form of a ban on issuance of ODIs or participatory notes as they are popularly known, a person close to the development said.
Curbs came to ease inflows
ODIs or PNotes are derivative instruments issued against an underlying Indian security—which could be shares or derivatives—by foreign portfolio investors registered in India to overseas investors who are not registered here or seek to trade anonymously.
At that time, the government had defended the move saying it was aimed at moderating inflows. Large inflows put pressure on monetary policy management in terms of containing growth of money supply (created through release of rupee funds released into the system on mopping up of dollars), and the risk of higher inflation.
“The scenario has changed now. We need to weigh global factors and the need to attract inflows “ said a person associated with the review exercise.
Even in October 2007, the finance minister had said there was no move to completely ban P-Notes and the restrictions were to moderate inflows. He said the move was in the interests of all investors.
However, in the past, the RBI had made clear its discomfort on PNs. When inflows soared to over $10 billion in September 2007, it sought a ban on fresh or incremental issuance of P-Notes. The RBI’s concern also related to the identity of the beneficiary of this instrument. Also, the apex bank has been consistently been more skeptical about PNs compared to Sebi and the finance ministry.
After the ban came into force, the share of P-Notes in total portfolio inflows is reckoned to have fallen from over 51% in August 2007 to almost half. Since January 2008, the Indian market has fallen in line with global trends. Morgan Stanley estimates that capital inflows have declined to $30-35 billion during April-August 2008 compared to $108 billion in the 2008 fiscal.
Incidentally, there are many sceptics who feel that tweaking the rules now may not have much of an impact in the short term. Their reasoning is that given the redemptions being faced by many hedge funds and that some of the biggest issuers of PNs—such as Merill Lynch—are themselves in trouble, the impact of a policy change could be quite limited.
But there are others who counter this by saying the growth story is still attractive. That the market is perceived as well-regulated is also another factor, they say.
The data collected after imposition of PN curbs would be placed before the board on Monday. Though the board had held some discussions on the matter at its last meeting too, it wanted to deliberate more on the issue before taking a decision.
Policymakers say capital flows should be eased to take some pressure off the rupee, which has been slipping against the dollar. The finance ministry has already eased some restrictions that were imposed on external commercial borrowings last year in order to increase capital flows into India as well as address corporates’ fund needs. Sources also said more measures that could boost capital flows into the country could be considered.
